from the never-give-up-the-.com-bubble-dream dept

Cross-posted from

To get a sense of how old the Goldman Sachs IPO lawsuit-and-maybe-scandal that Joe Nocera and Felix Salmon wrote about this weekend is, consider this: the alleged victim was a company named eToys. With the “e,” and the “Toys,” and the weird capitalization. Also Henry Blodget was the analyst who covered them at Merrill. Different times!

Nocera gives the basic facts and there’s something a little off about them:

The eToys initial public offering [in May 1999] raised $164 million [at $20/share], a nice chunk of change for a two-year-old company. But it wasn’t even close to the $600 million-plus the company could have raised if the offering price had more realistically reflected the intense demand for eToys shares. The firm that underwrote the I.P.O. — and effectively set the $20 price — was Goldman Sachs.

After the Internet bubble burst — and eToys, starved for cash, went out of business [in March 2001] — lawyers representing eToys’ creditors’ committee sued Goldman Sachs over that I.P.O.

The theory of the lawsuit is that Goldman screwed eToys on behalf of investors, pricing the IPO at $20 per share, rather than the $78 justified by demand, as evidenced by the fact that the stock briefly traded at $78 on the first day. An alternative theory is that Goldman screwed investors on behalf of eToys, pricing the IPO at $20 per share, rather than the $0 justified by fundamental value, as evidenced by the fact that the company went out of business 22 months after the IPO. Also it was called eToys, come on.

Are you surprised that investors sued Goldman too? Of course not, right? After all, they lost a lot more money. The surprising thing to me, as a wholly post-internet-bubble capital marketeer, is that the investor suit is not so much about “your prospectus said you would deliver childhood dreams and you instead delivered full-grown bankruptcy” as it is about the laddering and commission kickbacks that Nocera and Salmon describe. (Though: imagine the shareholder lawsuits if it had priced at $75.) Here’s Nocera:

Goldman carefully calculated the first-day gains reaped by its investment clients. After compiling the numbers in something it called a trade-up report, the Goldman sales force would call on clients, show them how much they had made from Goldman’s I.P.O.’s and demand that they reward Goldman with increased business. It was not unusual for Goldman sales representatives to ask that 30 to 50 percent of the first-day profits be returned to Goldman via commissions, according to depositions given in the case.

Let’s stipulate that some of the explicit quid pro quo stuff is bad, as are allegations that some clients conducted wash trades to kick Goldman sufficient commissions. Bad enough that various banks settled various lawsuits over dotcom-era hot-IPO-allocation practices, including Goldman settling with the SEC in 2005 over related “laddering” charges. The dotcom era is mostly in the past and so are those sorts of practices.

Others are not. Nocera cites an email from Bob Steel – then GS head of ECM, now Bob Steel – to Tim Ferguson at Putnam, saying in part “we should be rewarded with additional secondary business for offering access to capital markets product.” This email strikes me as pretty pretty standard even today. As Salmon says:

I’m sure if a determined prosecutor went hunting for similar emails today, she could probably find them. But I don’t know what the point would be. Because there’s nothing illegal about asking buy-side clients to send commission revenue your way — or even about explaining to them how much money you’ve helped them make.

True! There’s nothing illegal about telling your clients that you’re doing a good job for them.1 Is there anything scandalous? Obviously making money for investor clients by underpricing an IPO is in conflict with raising money for issuer clients by overpricing the IPO. That is the point of IPOs. There is that conflict, and the bank is there to mediate it, and the bank’s incentive to mediate is that it makes money from both sides.2

Salmon explains Goldman’s pitch to eToys:

On the page headlined “IPO Pricing Dynamics”, they explained that the IPO should be priced at a “10-15% discount to the expected fully distributed trading level” — which means not to the opening price, necessarily, but rather to the “trading value 1-3 months after the offering”. After all, this was the dot-com boom: everybody knew that IPOs were games to be played for fun and profit, and that the first-day price was a very bad price-discovery mechanism.

Right? eToys knew that it was leaving boatloads of money on the table for investors, and it knew that Pets.com and WebNonsense and the rest of its ilk before it had also left boatloads of money on the table for investors, and that that was why investors would give $164 million to a company called eToys that had – I mean, do I need to even say this? – never made a profit, and never would. That was the trade that eToys made: it let investors have an IPO pop, and in exchange they let eToys have an IPO.

The thing about this tradeoff is that it’s totally transparent. An IPO prices, and then it trades. You can look on Google Finance – back then it was probably AltaVista Finance but you know what I mean – and actually see where it’s trading. You can ask a bank for a list of their IPOs, and then see how they traded. If Bank X’s deals all left tons of money on the table and Bank Y’s didn’t, you might consider using Bank Y. Bank Y might even consider advertising this fact to you – just as Bank X is out advertising it to investor clients.

Now perhaps “totally transparent” overstates it a bit. The banks are masters of data-cutting, so they’ll focus you on the deals they want you to focus on (“joint books deals since 1998 excluding online pet product retailers”3). The “fully distributed trading level” blather is an example of that: 300% one-day pops look bad, so you focus clients elsewhere.

And investors have some advantages in their tug of war with issuers. They’re repeat players, for one thing, and they think about capital markets all day, so they have more incentive and ability to pay attention to which banks are systematically underpricing or overpricing deals. Also money: as Felix Salmon points out, Goldman likely made a lot more from investors kicking back 30-50% of their first-day eToys pop in commissions than it did on eToys paying its 7% fees. Even assuming explicit wash-trade kickbacks are gone, investors might still have the upper hand: at Goldman, for instance, 2012 equity underwriting revenues were a little under $1bn, and total investment banking advisory revenues were a little under $5bn, while equities division revenues – market making, commissions, and prime brokerage – were over $8bn.4 The more the trading side runs the place, the more its clients will tend to win out against issuers.

Nonetheless the right model is “constant tension,” not “one-sided screwing of issuers by investors.” One way to tell: if the issuers constantly got screwed, there’d be demand for things like direct auction IPOs that bypass investment banks. There is not. Issuers know that the model of banks currying favor with investors gets them better capital markets access, even if their stocks are the currency used to curry favor.

Another way to tell: if the issuers constantly got screwed, and the investors constantly made out like bandits, you’d see a lot of eToys-type lawsuits brought by issuers, and very few Facebook-type lawsuits brought by investors. That is not the case. There are more investor lawsuitsover the Facebook IPO than there are issuer lawsuits over any IPOs.5 That suggests that the issuers are doing okay.

1.Also, like: you’re the head of equity sales or whatever at a bank, and you go meet Putnam, and you ask yourself: what do I tell them about why they should give us more business? I submit to you that things like “our guys have taken you out to some great dinners,” “we reply to your Bloombergs promptly,” and “our research is nicely formatted” are all considerably less impactful than “we bring you IPOs that you make a lot of money on.” Capital markets deals really are a big part of the service that big banks offer their investor clients.

2.Thus eToys’s contention that Goldman owed it a fiduciary duty as underwriter is sort of nuts. Nocera:

As for the litigation itself, Goldman has argued that, contrary to popular belief, underwriters do not have a fiduciary duty to the companies they are underwriting. In recent years, this argument has held sway in the New York court system, although it has yet to be argued before the Court of Appeals.

What popular beliefs about underwriter fiduciary duties in IPOs do you think exist? And what could those duties be? If a bank’s duty was to maximize price on every IPO then it would screw investors over and over again and they’d get sick of it and lowball the banks’ next deals. Given that banks and issuers know more about their stock than investors, you’d end up with a market-for-lemons problem, and issuers as a class would be worse off. The point of the bank is to curry favor with investors – sometimes by leaving a little bit of money on the table for them – in order to help sell the next deal. That’s why you go to a bank: because they have a good relationship with investors. How do you think they got that relationship?

3.I once reviewed a fee run with a little footnote accurately describing it as “excluding REITs,” which would be fine (REITs are weird and many data runs exclude them), except that we were showing it to a REIT. I can’t quite remember, but I want to believe I had it changed.

from the crackdown-time dept

After Sarbanes-Oxley came into effect, it made it exceptionally more difficult for startups to go public. The additional expense of going public was prohibitive for all but some of the very, very biggest success stories. Clearly, in the late '90s it wastoo easy to go public, but Sarbanes-Oxley went too far in the other direction. There are some efforts underway today to carve out some reasonable exceptions for successful, growing startups that will allow them to go public without taking on the full expense of SOX compliance, but the other thing that happened was that the industry just routed around the limitations, often setting up private secondary markets/exchanges for pre-IPO shares. In many ways, this is a worse situation from a public policy situation, because it limits these markets to just those well-connected enough to access them, rather than to the wider public.

Of course, I've also wondered how these were legal, as they often appeared to be offering up shares outside of the basic rules of equity offerings under the SEC. It appears that the SEC has finally noticed this as well:

Securities regulators took enforcement action against an online trading platform and two private funds offering Facebook shares on Wednesday, the first action in a year-long probe into the lightly regulated world of private company-share trading.

The Securities and Exchange Commission charged SharesPost, which matches buyers and sellers of private shares, and its CEO Greg Brogger with failing to register as a broker-dealer before offering the securities.

The SEC also brought charges against two private funds and their managers for allegedly misleading investors about hidden fees in Facebook stock offerings.

Of course, this is all going after the symptoms of the larger problem, rather than dealing with the actual problem, created by excessive SOX rules. Allow for a more reasonable setup for successful companies to actually access the public markets, and there's no more demand for these private offerings.

from the this-is-not-efficient dept

After the dot com bubble burst, quickly followed by major accounting scandals such as Enron, Congress, in the way that it normally does, overreacted with a kneejerk response. The most obvious part of this was the Sarbanes-Oxley rules, which didn't do much (if anything) to actually prevent future frauds, but did make the cost of being a public company much, much, much higher -- effectively creating a serious tax on startups looking to go public. It also built up an entire industry around SOX compliance, that almost guarantees the law can never be repealed. In response, an already weak IPO market went almost entirely dormant, an even as things picked up with startups, fewer and fewer actually wanted to go public. It was just too costly, and the potential liability for execs was way too high. Google resisted going public for as long as it possibly could, before it finally tripped an old SEC rule, that required companies with more than 500 shareholders and over $10 million in assets to effectively act as a public company -- at which point, it figured it might as well just go public.

That was in 2004. In the six years since then, a number of other companies have worked on a number of loopholes and ways to avoid going public even longer. Witness Goldman Sach's recent deal to invest a ton of its investors' money into Facebook shares -- which normally would have tripped this rule -- except that Goldman is playing a little game, and setting it up so that it pretends there's only one shareholder, keeping Facebook away from the magic 500 number. The SEC is apparently already looking into this.

But even before the Goldman/Facebook deal became public, the SEC had apparently begun probing the rise of these new efforts to let hot startups sell shares on a market, without actually going public. Hot startups including Facebook, Twitter, Zynga and LinkedIn have all been heavily involved in such markets, which basically let employees of those companies get many of the benefits of being a public company, without the massive costs and regulatory oversight.

This is, in many ways, the exact opposite of what was intended with things like SOX -- which was designed to increase oversight. But, instead, it's done the opposite. The end result is that wealthy clients of Goldman Sachs and other Wall Street firms can invest in these companies, but others cannot. Now, some might claim that this is a "good" thing, in that the general public shouldn't be investing in highly risky stocks that could easily collapse. But, it's also creating a tiered system where these companies are able to avoid going public for much longer, but the wealthy and well-connected can get in at about the same point that the public used to be able to get in. And, they are buying. Goldman has already announced that it's already oversubscribed.

While some are cheering on the SEC investigation of these practices, it seems to be missing the real lesson here: which is that money always seeks out the unregulated loopholes, and the more you regulate, the more hurdles you put up to efficient markets, the more money will pour into whatever side pools that are left unregulated. And that's dangerous. The economic collapse of 2008 was a result of this, as tons of money went into unregulated areas of the market and was sliced and diced in increasingly misleading ways. The classic response is to just regulate those areas -- but that ignores the fact that there will always be new loopholes and new unregulated areas that money will rush into. We're seeing it all the time.

What's happening with Goldman, Facebook and those other startups can be traced back to SOX in the first place. If we didn't make it ridiculously burdensom to be public, then firms wouldn't seek out these hidden alternatives. But our government refuses to let the market ever learn lessons. The lessons from the dot com bubble and Enron and such should have been that people learned to be more careful in their investments. But the government rushes in and sets up a pretend safety net -- so we never get to learn.

from the did-you-invest? dept

AdamR points us to yet another sickening example of the serious sense of entitlement held by entertainment industry execs. Steven Levitan, a Hollywood producer of various TV shows is apparently pissed off that Hulu might be going public. He apparently complained on Twitter about how unfair it was that the makers of the shows wouldn't get a cut of any IPO proceeds:

"Some estimate Hulu IPO could bring in $2 billion. What do the content providers get? Zero. What is Hulu without content? An empty jukebox"

Yes, and where are those TV shows without Hulu? Most of them are shared online via unauthorized means where the content providers get nothing. When they're on Hulu, at least they do make money. Hulu is going public because of the service it provides, not because of the content. If it does well in the IPO, then it has more money to invest in the service which, in theory (if they don't muck it up -- and there are signs that they are very much mucking it up), should help the content providers make more money. To claim that they shouldn't go public without giving some of those proceeds to the content providers is totally missing the point, and shows a fundamental misunderstanding of how technology and capital markets work (from a Hollywood producer? what a shock...).

But, really, this is yet another example of the entitlement mentality. Yes, the content producers made the content. That's great. But they didn't build Hulu. They didn't invest in Hulu. They didn't pay the bandwidth costs or develop the interface. They didn't pay the salaries or negotiate the licensing agreements. Yet now they just want money handed to them... even though the company already does, in fact, pay content providers for the content that it licenses? Pure entitlement. Levitan is asking for money he doesn't deserve. Anyway, if he really wants to feel better, he should be happy to note that Wall Street doesn't think much of the IPO idea.

from the money-makes-the-world-go-'round dept

The regulatory nightmare of going public, means that it's all paperwork and lawyers, rather than focusing on growth, innovation and markets. Sarbanes-Oxley remains a key problem here.

For startup founders, it's become a lot more tempting to just sell out to someone big -- because it's a lot easier, but can still earn you enough money to totally change your life.

Again, neither of these issues are all that new, but a decade ago, the focus for most startups was very much on building companies that could go public and standalone. Admittedly, in the dot com insanity, a ton of startups went public that had no business whatsoever being public standalone companies, but there's reason to fear that we've gone too far in the other direction.

Real innovation depends on creative destruction, as newer startups come up and take over from the old legacy players. That's where innovation really thrives. And, while I don't think all great companies need to go public, it could be problematic if each great startup instead just sells out to the legacy players from the last generation. Those companies are often where new innovations go to die, rather than to thrive. This doesn't mean we should go back to allowing just anyone to go public, but if we make it so difficult for good innovative companies to go public on their own that they're forced to sell out to other companies, we definitely lose some of the creative destruction that has made Silicon Valley and the tech industry thrive in the past.

from the good-or-not? dept

There's been lots of buzz in Silicon Valley thanks to OpenTable having a 1999-style IPO, where the stock popped 70% on the first day (which, means that OpenTable effectively left a huge chunk of change on the table). But, of course, many people are asking if this finally means that IPOs can come back in fashion for venture-backed startups. Just a few weeks ago, we discussed how some believed that tech IPOs were primed to come back, though I was (and still am) skeptical. As the first link above shows, looking at OpenTable's financials makes you wonder how anyone would invest at the dollar value it hit. It makes little sense. So, this could just be an anomaly, as investors who have been sitting on cash for too long and are desperate to find different places to dump it got excited about a "new" tech IPO. But, unless the companies going public have better fundamentals, it seems like they'll start finding better places to put their cash. Instead, this seems like those sitting on too much cash venting a little steam just because.

from the theories... dept

Venture capitalist Fred Wilson has laid out his reasons for why he believes the IPO market is about to come back. It's a worthwhile read if you're interested in the startup ecosystem. While I tend to agree with Fred on many different things, on this one I'm not at all convinced. I do agree that there are a growing number of companies who in the past would have gone public about now, but are held back by the near total lack of willingness to risk running the IPO gauntlet. The one thing that we agree on is that investors are going to start looking to put money into new investments sometime soon (there's way too much money being flooded into the market, and it needs to go somewhere). I'm just not convinced it will go into the traditional IPO market. I think it would be good if the IPO market opened up somewhat, but a flood wouldn't be good. It would create another bubble scenario. My guess (at this point) is that the money will go into something unexpected -- perhaps even new financial instruments. However, I'm curious: where do people think all the money that's being dumped into the economy will flow? What's the next bubble going to be?

from the well,-it's-financials-are-quite-a-bit-worse... dept

Throughout 2002 and 2003 there was a ton of speculation concerning when Google would "finally" go public. Everyone knew the company was making a lot of money and growing fast, but it wasn't clear how big the company was nor how successful. The company's top execs insisted that they did not want to go public and tried to avoid any discussion of it. However, in early 2004, the company tripped a specific level that required them to start reporting their earnings publicly. If you have over 500 shareholders, even as a private company, you are required to file earnings reports, just as if you were a public company -- and at that point, Google execs realized there was no additional benefit in remaining private. So that single event pushed Google to finally IPO, and some were beginning to wonder if the same might push Facebook into an oncoming IPO.

It looks like that won't be happening.

Facebook's lawyers requested and received a special exemption from the SEC, allowing the company to not report its earnings publicly, even if it goes over 500 shareholders (which is likely to happen relatively soon). The exemption will remain in place until the company decides to go public or is acquired. You have to think that some folks at Google are kicking themselves for not trying to do the same thing. Either way, it's pretty clear that Facebook doesn't have the financial numbers that Google had at the time it went public, either -- so forcing Facebook to go public at this time probably would have made a lot less sense than it did for Google, who had fantastic earnings.

from the how-the-game-is-played dept

Valleywag points us to a rather scathing profile of late stage "investment" firm Advanced Equities in Chicago. Valleywag refers to the operation as a venture capital firm, but the details suggest it's a bit different than a traditional VC firm, which tends to raise a fund and then invest it as deals come up. Instead, it looks like AE is more of an investment hunter. While it does appear to have some money under management, it sounds like other VCs come to AE to go out and find investors to invest in the latest round. Tellingly, rather than referring to these investors as "limited partners" like a regular VC firm, AE refers to them as "customers." And, from the Forbes story, it sounds like those "customers" are basically unsophisticated investors who don't recognize what they're getting into.

Rather than billionaires, say former AE brokers, many clients are doctors, lawyers and dentists who lack the sophistication of typical institutions and ultrarich VC investors.

As an example, they cite one such case:

In 1999 AE sold Constance Kamberos, now 82, $330,000 worth of "bridge" notes issued by Hymarc, a firm it backed. Kamberos says the notes were pitched as a relatively safe way to earn a 12% yield. When she didn't get paid by Hymarc, Kamberos visited AE in Chicago's Loop. After she had a heated exchange with Daubenspeck, AE had the cops haul her away, Kamberos says (AE says she visited repeatedly and was hauled out by building security)

These aren't stories you hear with a typical VC firm. These sound more like stories you hear from "boiler room" operations tricking unsophisticated investors out of their hard-earned savings. Yet, as Forbes notes, big Silicon Valley VC firms like Kleiner Perkins and NEA love to talk up AE. Hmm. Then, let's recall that the IPO market has pretty much dried up for startups lately, and you can start to put two and two together.

In the bubble years, the "business model" of certain venture backed startups, was basically to sell equity to the last sucker. In the late 90s that was the public market -- consisting of a bunch of unsophisticated retail investors who would overpay for junk. But it's harder to get access to the public markets, and at least a few of the suckers have learned at least some of the lesson. However, if you can convince those suckers that they're getting in on a special deal -- say a "late stage, pre-IPO startup backed by the biggest names in Silicon Valley" the lessons learned from the last bubble go out the window. Reading this, it would appear that AE's function is to bring those "last suckers" to these startups and their VCs without going through the painful public market IPO process.

What's not clear is whether or not the VCs (and startup founders?) are taking money off the table directly during these late stage financings -- but it wouldn't be all that surprising (such deals are increasingly common these days). And, it would explain situations like the one in the Forbes article where AE helped gather up $45 million from "customers" to invest in a company called Agami. Five months later, the company no longer existed. Even people who worked at the company had no idea what happened to the money. The Forbes piece also notes that AE often pumps up the valuation of the startups in question, meaning that an earlier stage VC could be selling its shares as part of that "investment" (i.e., the money would go straight to the earlier investors, rather than the company), allowing them to still get a positive ROI on a company about to go broke.

If the Forbes report is accurate, then it certainly sounds like VCs may have figured out a different way to find that "last sucker" it needs to cash out certain investments without having to take a company public. It doesn't necessarily sound illegal (though that may depend on the details -- and there are apparently a bunch of lawsuits floating around AE). Never underestimate the ability of early stage investors to eventually find a bigger sucker to take their bad investments off their hands.

from the first-time-in-30-years dept

It's rather surprising to find out that, for the first time in about thirty years, not a single venture-backed company went public last quarter. Even in the worst of the various downturns that have happened over the past thirty years, there were always at least a few venture-backed companies that were able to make it out. This news has some folks fretting about what it means for the VC community -- with many pointing out that a bunch of VCs have moved away from "quick flip" internet investments into more long-term alternative energy bets.

I'd also guess that Sarbanes-Oxley has a lot to do with this. Going public is a lot less appealing these days thanks to the expenses required under that law. Rather than "cleaning up" the market, it's basically made going public a toxic process, so that everyone stays private and looks for acquisition opportunities. That said, it was obvious during the boom years that companies were going public way too quickly -- and being a public company is no picnic, with the required short-term thinking it demands.

So, what happens instead? There's been some talk of creating some sort of middle road. Rather than taking companies fully public, or selling them off to big players, what about a limited market of private equity investors who would let some of the original VCs and founders cash out, while keeping the company away from public market reporting requirements? This could potentially make a lot more sense for all involved. It basically adds another layer between VCs and the public markets where the private equity guys could either eventually take the company public or sell it off themselves. Even if this doesn't really work out, one thing is pretty clear: VCs will find a way to get money out of investing in startups, even if it's not in taking companies public.